Finance: Whoops. Another pounds 1m gone

Eighteen years after the first compulsory competitive tendering laws were introduced, many councils are still breaking the law by running losses on activities won against private-sector competition. Last month Cardiff City Council revealed that it had made a loss of pounds 1m-plus last year in managing its housing stock, after a new computer system failed to monitor spending.

Also in July, the Secretary of State for Scotland, Donald Dewar, intervened to close down the works departments of North Lanarkshire and East Ayrshire councils, which were running deficits between them of more than pounds 7m. In Lanarkshire, weak management had allowed 2,000 manual workers to earn more than pounds 20,000 a year each; one plumber earned bonuses of pounds 43,500 on top of his basic wage of pounds 10,600.

Meanwhile, in Liverpool, there have been a series of financial failures by the council's works departments. This led last week to a crisis meeting between Hilary Armstrong, the local government minister, and Mike Storey, leader of Liverpool Council. The Government has instructed the council to close its grounds maintenance department and award the contract to the private sector. The council is asking for a period of grace to transfer its parks into the hands of newly formed trusts, to award maintenance contracts to commercial businesses.

This year, 15 councils in England alone were told to take urgent action to stem losses on contracts awarded to in-house teams, usually called direct service organisations (DSOs), or sometimes direct labour organisations (DLOs). Under compulsory competitive tendering (CCT) legislation - to be replaced by potentially stricter new Best Value laws - DSOs must break even after putting aside 6 per cent of costs as a capital financing charge.

The Department of the Environment, Transport and the Regions argues that, with only 15 local authorities given notice to put right failures this year - and with just eight of these given further directions for failing to make sufficient progress - this is an improvement. Last year, 31 councils failed to hit their financial targets.

The Association of Direct Labour Organisations agrees. Nick Walkley, ADLO's principal adviser for Best Value, says: "They are not in as bad a mess as they appear, and it is resolvable. Things have gone wrong, but there is an opportunity for councils to put their own houses in order. Treatment of them has sometimes been heavy-handed. If you look at the number of DSOs in difficulty, it has gone down significantly over the last five or six years. There are a lot of good-performing DSOs: some can compete with the best of the private sector."

A different view is taken by their competitors. Cliff Davis-Coleman represents the Public Contractors' Association, and says: "DSOs are in this mess because the last government decided, for reasons best known to themselves, not to pursue them, and because these authorities, with the connivance of the Labour Party, were looking the other way. There is a certain irony that it is now a Labour government that is jumping all over them.

"It is going to create problems for Best Value. That is why the Government is talking about creating regional performance indicators, because many of these services have never been properly subject to market testing, and therefore there are no real benchmarks to test them against. It will take five years before these things are sorted out.

"These problems are widespread. I would say that two-thirds of local government has not looked at the costs in their DSOs since 1988."

Mr Davis-Coleman believes that the traditionally close relationship between trade unions and the Labour Party has led Labour-controlled councils to feather-bed their works departments, protecting them against competition. However, it is not only in Labour councils where DSOs have performed badly.

Surrey County Council has been Conservative-controlled for most of its history, except for a short period recently when it had no overall control. Yet Surrey's DSO, called Surrey Operational Services, was found to be illegally cross-subsidising its loss-making grounds maintenance division from its profitable waste disposal division. The managing director of Surrey Operational Services, Norman Allison - who has since died - was found to have falsified accounting returns to the council for three years.

Mr Allison was arrested and subject to a Serious Fraud Office investigation, which concluded that while he was guilty of improper accounting, it was not for personal gain, and that there was not sufficient evidence to prosecute him.

A report by Surrey's auditors, KPMG, concluded that the council would have saved pounds 27m if it had externalised its rubbish disposal service, though this is disputed by the authority.

Since the crisis in its DSO, Surrey has carried out major organisational reforms. This led to its externalising the grounds maintenance operation to the contractors Sita UK, and its highways construction division to Balfour Beatty, and it will transfer out its waste disposal service to the private sector later this year when it lets out a 25-year contract, for which the DSO will not be allowed to bid.

Surrey council has concluded that the game is up for DSOs. A spokesman, Tim Edwards, says: "Public sector companies simply cannot compete. The private sector can cross-subsidise. The illegal practice conducted by Norman Allison was no more than he would have done legally in the private sector. But he ran it as if it was his own private company, and as a result discredited a lot of legitimate DSOs."

The Association of Direct Labour Organisations, naturally enough, is less pessimistic. Nick Walkley, a spokesman, does agree, though, that DSOs cannot compete evenly with private sector contractors. A recent government White Paper indicates that councils will be empowered to enforce contract compliance on contractors, preventing their winning work by employing staff on worse conditions of employment. But ADLO also wants the Government to permit DSOs to carry out work outside their own areas, which they are prevented by law from doing. ADLO says the Government is currently dithering on whether to implement this change.

The risk is that if DSOs are unable to achieve economies of scale by winning more contracts, they will simply die slowly anyway.